By Chris Ishida, Director, Financial Planning, Financial Engines
In Part 1 of our “Making Ends Meet” series, Bridging Expense Gaps During and After the COVID-19 Crisis (avaiable in the Education Center), we described some of the financial resources that could help bridge your household’s expense gaps in the wake of the COVID-19 economic slowdown. In Part 2, we look at how one of those resources — personal loans — may help you pay the bills until the economy gets moving again.
What’s the (FICO) score?
Before we get into loan types, interest rates and application processes, let’s examine one of the most important factors in the borrowing world — your credit score, which lenders use to help gauge your ability to repay a loan on time.
The credit score used by more than 90 percent of top lenders is the FICO score, a three-digit number that ranks your creditworthiness. Think of it as a summary of your credit report. It’s a measure of how much credit you have and how long you’ve had it, how much of your available credit is being used and your record of paying on time, among other factors.
Scores run from 300 to 850. The higher the score, the better. The scale is divided into five categories, from “poor” (below 580) to “exceptional” (800 and higher). If your score is 720 or above, you’re generally in the excellent credit range, which should make it easier to get a loan and help you qualify for a better interest rate.
To give you an idea of why your FICO score matters, here’s a look at estimated online personal loan APRs (annual percentage rates) by FICO score range, as reported by NerdWallet’s April 2020 Lender Survey:
As you can see, the difference between fair and excellent credit is significant. You can improve your FICO score by following these tips from myfico.com
- Pay bills on time.
- Get current with any missed payments
- Keep balances well below the credit limits on credit cards and revolving credit accounts
- Don’t close unused credit cards
- Don’t open lots of new accounts within a short period of time
Check your credit reports for accuracy
TransUnion, Equifax and Experian are the three big credit reporting bureaus. Each company issues credit reports on individuals to lenders, insurers and other businesses. Before you apply for a loan, review copies of your credit reports to make sure they are accurate. The three bureaus do not share information with one another, so your reports from each firm may be slightly different. Under federal law, you are entitled to a copy of your credit report from each bureau every 12 months. You should make a habit of doing this even if you’re not in the market for a loan so you can ensure your reports are up to date. A best practice is to request your free report from a different credit bureau every four months.
If you’re about to apply for a personal loan, you can get all three reports at once for free from annualcreditreport.com. This is the only official website that does not charge for the reports. In response to the COVID-19 crisis, all three credit bureaus are offering consumers access to their reports on a weekly basis through April 2021.
Choose a lender
There are three primary sources for personal loans:
Banks — Banks may offer competitive rates, with discounts for banking customers, but they typically have tougher eligibility requirements and can take longer to fund your loan compared to online lenders. If you value personal interaction and the security of knowing who is handling your loan, a bank might be a good place to start. Also, you may be able to negotiate a lower rate or qualify with a lower credit score if you’re talking to a person with whom you already have a banking relationship.
In the aftermath of the 2008–2009 subprime mortgage crisis and recession, many traditional “brick and mortar” banks pulled back on consumer lending. While banks have loosened up a bit in the last of couple years, many are still reluctant to offer unsecured personal loans.
Online lenders — Online lenders are stepping in and offering unsecured personal loans that would not be available at a traditional bank. Online sites like Avant Loans have simplified the process of taking out a loan. Because online lenders don’t have the overhead expenses of maintaining a physical bank, they may be able to offer lower loan fees. For the same reason, online interest rates are usually lower than those of banks if you’re applying for a secured loan, such as a home mortgage or auto loan.
Most online lending is unsecured, which means you’re not putting up collateral that the lender can keep if you don’t pay your debt. Unsecured loans are riskier for the lender, so they come with higher interest rates. If you need a personal loan and borrowing online is your only option, even at a relatively high interest rate, you’ll likely pay less than you’d pay in credit card interest. One positive aspect of online interest rates is that they are usually fixed, so you’re not vulnerable to broader interest rate fluctuations. A fixed-rate loan allows you to know exactly how much interest you’ll pay for the life of a loan.
Credit unions — Credit union loans often have lower interest rates than those of banks and online lenders. If you have a less-than-stellar FICO score, you may find credit union loan officers more willing to consider your overall financial picture when determining your creditworthiness.
There are two types of credit unions: federally chartered and state chartered. At federal credit unions, APRs on most types of loans are capped at 18 percent. Over the past five years, federal credit union loan APRs on three-year loans have averaged 9.29 percent, while the average at banks was 10.18 percent, according to data from the National Credit Union Administration. Rates at state-chartered credit unions have averaged 11.43 percent over the past five years, according to economists with the Credit Union National Association. Your credit union may choose to charge an application fee that isn’t part of the APR.
Pre-qualify to see where you stand
Personal loan interest rates currently range from about 5 to 30 percent. The actual rate you receive depends on factors such as your credit score, credit history, annual income, existing debt and whether you get a loan from a bank, credit union or online lender.
Because rates and terms vary among lenders, we recommend pre-qualifying for several personal loans so you can compare offers. Pre-qualifying gets you access to potential loan terms, like the amount you qualify for and the interest rate, but it does not guarantee that you’ll get the loan. Pre-qualifying for a loan should not impact your credit score. Lenders do a “soft” credit check to determine your basic creditworthiness and that inquiry will not show up on your credit report.
The pre-qualification process generally involves the following steps:
- You fill out a pre-qualification form, sharing such information as your income, occupation and existing debt
- The lender performs a soft credit check, assessing your credit score and history. This gives the lender a sense of how risky a borrower you may be
- The lender either denies or grants your pre-qualification. If you pre-qualify, you’ll receive information about the loan you may receive, including the rate and loan amount
If you continue with a loan application after pre-qualifying, the lender will verify your financial history and perform a hard credit check, which will appear on your credit report for up to two years and may temporarily shave a few points off your FICO score.
In Part 3 of our “Making Ends Meet” series, we’ll take a look at four other loan-based resources that might be used to support your finances: home equity loans, home equity lines of credit, mortgage modifications and payday alternative loans.
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